Is an S corporation right for you?
Posted On: 1-20-2017 | Posted By: John Weaver, CPA and Nicole Beck, CPA
S corporations have become a popular entity of choice for many operating businesses. It is a “flow-through” entity, meaning that it passes all its income and losses through to its shareholders without self-employment (SE) tax or the “double-taxation” facing C corporations. But before you make the leap, you should know the requirements and tax consequences of organizing as an S corporation.
To qualify for S corporation status, the business must be a domestic entity with no more than 100 shareholders or members. Shareholders/members can only consist of individuals or certain trusts and estates. They may not be partnerships, corporations, or non-resident alien shareholders; however, a single-member LLC can qualify as a shareholder/member.
S corporations can only have one class of stock. Therefore, income and loss allocations and distributions must be allocated by stock ownership percentage. No one shareholder or group of shareholders can get preferential treatment over others.
Because an S corporation’s profits are not subject to SE tax, the IRS requires that shareholders receive reasonable compensation for services rendered in the form of wages. Wages are subject to FICA and Medicare taxes, which are the basis for SE tax. Therefore, a shareholder theoretically pays SE tax on the wages they earn but not on the additional profits of the company.
In most cases, the additional profits of the company are available to be spread among the shareholders in the form of distributions (similar to dividends in a C corporation), but they are not subject to additional taxes. These should be structured as periodic dividend payments, not just extra money paid along with payroll or when expenses come up.
An S corporation can be established from inception with the issuance of stock certificates, filing annually with the secretary of state to keep registration current, and filing Form 2553, Election by a Small Business Corporation, with the IRS. Or, you can set up a business as an LLC and file an election to be treated as an S corporation for income tax purposes. The company will remain an LLC for legal purposes and be an S corporation for income tax purposes, which cuts down on extra secretary of state paperwork.
If a company was created as a C corporation, it can also change its status to a S corporation. A C corporation’s income is taxed at the corporate level. Dividends paid to shareholders, are not deductible by the corporation, are passed to the shareholders and are taxed on the individual’s personal income tax return. This creates double taxation, once at the corporate level, and again at the individual level. By converting to an S corporation, shareholders can avoid that double taxation.
Be aware of built-in capital gains
If a C corporation converts to an S corporation, the S corporation could have a net unrealized built-in gain. The built-in gain is calculated by taking the fair market value of the assets on the day of conversion, less any liabilities that would be assumed and the current adjusted basis of those assets. There is a five-year period during which, if any of those assets are sold, the unrealized built-in gain is recognized and is taxed at the highest corporate tax rate. Provided these assets are held the duration of the five-year period, they are generally free to be treated as any other S corporation asset. The built-in capital gains tax is no longer an issue.
The election process
In the initial year, the election to be treated as an S corporation (Form 2553) must be filed, at the latest, by the due date of the first income tax return.
If the entity is already in existence, the election to covert to an S corporation must be made by March 15 of the year you want to switch to S corporation status. For example, if a company wants to be an S corporation for 2017, they have until March 15, 2017, to make the election with an effective date of January 1, 2017.
Is the S corporation structure best for your business?
There are advantages and disadvantages to each business structure, and finding the right fit for you is important to the health and growth of your business. S corporations are a popular structure, especially for a closely held operating entity, but you need to weigh the pros and cons before making the election.
If you would like more information regarding a potential switch to an S corporation, please contact your WK advisor at (573) 442-6171 or (573) 635-6196 to help determine the most tax effective way to do so.